A breach of a financial covenant would typically act as a catalyst for discussions between the borrower and its lender(s). How a negotiation or restructuring related to COVID-19 plays out is likely to depend on the timing and severity of any breach. But many borrowers are now considering whether the issue can be mitigated by introducing COVID-19 exceptional items.
In this paper, KPMG’s debt advisory, accounting advisory and legal services professionals consider:
Every borrower agrees on a set of financial covenants designed to warn lenders about a deterioration in financial performance. If these covenants are breached, lenders can bring a borrower to the table to address general issues and underperformance. While they are designed to encourage a borrower to undertake self-help measures, covenants also enable lenders to take more draconian measures, like enforcement, if the borrower does not, or cannot, take action to remedy the situation.
Borrowers typically negotiate a series of adjustments within financial covenants to give an agreed “fairer” reflection of the underlying performance of the business. For example, this might include adding back the one-off costs of closing an underperforming division to give a more accurate view of the ongoing business.
We advocate an open and transparent relationship between borrower and lender(s). Keeping lenders informed and highlighting any potential breach before it happens helps to build trust and can pay dividends in the long term.
Requesting, negotiating and agreeing a relaxation in covenants in advance of a potential breach can provide management teams with the time and flexibility to implement certain financial or operational changes for the benefit of the business.
When approaching lenders with such a request, preparation is key, especially in the current environment. Ensuring that company information and a positive “credit story” are clearly and explicitly presented to lender credit teams is imperative for an efficient and successful result.
For the borrower, the ideal outcome is the waiving of covenants, meaning no testing for an agreed period. But lenders will often want greater assurance and we have seen recent examples where they have challenged such waiver requests. Lenders typically achieve the assurance needed by agreeing to amend covenant calculations or testing levels, to maintain a “trigger”, which is set off in the event of additional underperformance or if another element of the covenant calculation is worse than expected.
Where covenants are altered, this may include using historic or annualised EBITDA figures, or using some other adjustment to EBITDA in subsequent covenant testing. The lender may also want to introduce entirely new tests (for example, a minimum liquidity test) as part of the agreement to permit a change.
Agreeing a consensual approach to the relaxation of covenants isn’t always straightforward. For example, some organisations may have upwards of 50 different lenders across the bank and private placement markets, creating a significant logistical challenge and cross default issues. In certain situations, a borrower may find that its loans have been traded in the secondary market and it may be hard to engage with new lenders – or worse, those lenders may actively seek a default to take control of the distressed entity.
That makes it important to fully understand and explore what flexibility exists within the facility documents – such as exceptional items – to help avoid any breach in these scenarios.
Carve outs in financial covenant definitions generally allow for the adding back of “exceptional items”. These exceptional items are not defined under IFRS Accounting Standards or UK GAAP (Generally Accepted Accounting Practice) and their definition within facility documentation is usually not exhaustive. It may include language along the lines of, “means any material items of an unusual or non-recurring nature which represent gains or losses including those arising on…”, followed by a non-exhaustive list of examples.
Therefore, the definition of exceptional items is typically subjective, which can be very important as the determination of what constitutes an exceptional item may impact covenant compliance, and affect resulting creditor confidence, public announcements and auditor going concern assessments.
Arguably, the COVID-19 related shock is (or, at least, hopefully will be) unusual or non-recurring in nature, although agreeing the scale of any adjustments represents an unprecedented challenge. Borrowers need to quantify and successfully present the full impact of the pandemic, relative to the true underlying financial performance and position of the business.
Lender reaction to, and acceptance of, these subjective amendments is a critical test of stakeholder dynamics and will dictate how COVID-19 restructurings evolve.
EBITDA is the most common measure of financial performance because it is believed to be the best profit and loss account proxy for cashflow generation. EBITDAC (Earnings before Interest, Tax, Depreciation, Amortisation and COVID-19) is the concept of trying to arrive at the COVID-19-adjusted cashflow generation capacity of a business.
In facility documentation, a number of potential add backs to EBITDA will be listed (the way in which this is expressed will be specific to each agreement) which will cover both cash and non-cash items. Some add backs will be loss related, while others will be specific costs/expenses. While the latter should simply equal an amount paid, quantifying the former relies on understanding the impact on both revenue and costs.
To provide some examples of what could be considered as adjusting items, below is a case study of a restaurant chain that was forced to temporarily close due to COVID-19.
Application and quantification of these add backs will be more contentious for certain borrowers, and perspectives vary widely. Borrowers should consider how far they push their application of these adjustments, while remaining cognisant of the fact that they will not be able to flex which ones to apply and when to apply them. A borrower not adjusting for foregone profits at a June test date, may struggle to justify the add back in September if that’s required to navigate a later test.
Whilst EBITDA(C) may be the most high-profile metric of performance in financial covenants, other key metrics will also be affected e.g. cashflow, valuation, and net assets. Borrowers will also need to consider these during review of their financial covenant forecasts and discussions with lenders.
Additionally, alongside financial covenant concerns, borrowers may, of course, be exposed to other Events of Default (both actual and potential breaches) within their financing agreements. Even potential breaches can have a significant impact under finance documents and borrowers need to tread carefully around these to avoid further friction with lenders.
The impact of COVID-19 on covenants and the wider financing agreement is likely to affect nearly every borrower. Certain borrowers and lenders are already acting to remedy any forecast covenant compliance issues, with some larger, listed companies announcing the agreements they have reached. Whatever the approach borrowers take in lender discussions, they will need to collate a robust set of information that clearly sets out the impact on financial performance and position.
KPMG’s debt, accounting and legal practices can help you understand the impacts of the pandemic on your covenants and discuss your approach to negotiations.